External audit and tax evasion: evidence from India

ABSTRACT

This paper aims to examine the relationship between voluntary external audit by privately held firms and tax evasion in India. We use data generated by the World Bank Enterprise Survey which is based on interviews conducted over 2013 and 2014 only. Our final sample includes 7,262 privately held Indian firms. Our research reports the following results for privately held companies in India: (1) Firms with voluntarily audited financial statements are more likely to evade taxes; (2) Firms that face financing constraints are more likely to have stronger relationship between voluntary external audit and tax evasion; (3) Firms operating in Indian states with better business environment (as measured by ease of doing business) are more likely to have weaker relationship between voluntary external audit and tax evasion.

KEYWORDS:

• Tax evasion
• voluntary audit
• privately held firms
• world bank enterprise survey
• india

JEL CLASSIFICATION:

• H26
• M42

Acknowledgement

We thank research workshop participants at the Georgia State University School of Accountancy and participants at the 2021 European Accounting Association Virtual Congress and the 2020 American Accounting Association Virtual Meeting for their comments.

Disclosure statement

No potential conflict ofinterest was reported by the author(s).

Notes

¹ The definitions of tax avoidance and tax evasion have been paraphrased from descriptions in Crocker and Slemrod (2005), Hanlon and Heitzman (2010), Hanlon, Maydew, and Thornock (2015), and Wilde and Wilson (2018)..

² There has been some theoretical research on individual and corporate tax evasion. For example, Allingham and Sandmo (1972) model the tax evasion behaviour of individual taxpayers as an expected utility maximizing choice. Crocker and Slemrod (2005) model corporate tax evasion in the context of the contractual relationship between the shareholders of a firm and a tax manager who possesses private information both about legally permissible tax avoidance and illegal tax evasion..

³ There have been some studies measuring tax evasion at the macro (country) level. For a review of this literature see Khlif and Achek (2015)..

⁴ Hanlon, Maydew, and Thornock (2015) study illegal investor-level tax evasion and find that U.S. individuals hide funds in entities located in offshore tax havens and then invest those funds in U.S. securities markets in order to evade U.S. personal income taxes..

⁵ Wilde and Wilson (2018) use the term ‘tax planning’ to reflect the notion of intentional efforts made to reduce corporate tax burdens. They then argue that tax avoidance is the outcome from tax planning..

⁶ An Ernst & Young partner specializing in selling tax services claimed that ‘We pride ourselves in being a liberal economy; the central feature of such an economy is that residents are free to undertake the activities that they wish [avoid taxes], provided the activities are not unlawful’ (Irish Times, 7 May 2004)..

⁷ Corporate managers resort to tax evasion and avoidance because they are constantly faced with resource allocation decisions. By hiring external auditors for these purposes, managers aim to improve their cash flows and performance..

⁸ McGuire, Omer, and Wang (2012) also note that their findings “suggest that even within public accounting firms’ role as the external auditor, there are still avenues for greater tax avoidance” and that ‘overall experts are able to combine their audit and tax expertise to develop tax strategies that benefit clients from both a tax and financial statement perspective’..

⁹ Stronger institutional environment is also very likely to improve the information environment of firms. Superior information environments facilitate the monitoring of firms’ activities and reduce the ability of firms to engage in aggressive tax evasion (Gallemore and Labro 2015). Therefore, it is possible that firms should find it hard to use auditors for tax evasion in jurisdictions with stronger institutional environment..

¹⁰ We did not include the state dummies (SDUM) in our analysis because of high correlation between ENVIRONMENT and SDUM..

¹¹ The World Bank Enterprise Survey did not conduct surveys in India after 2013–2014..